In
the middle of May this year, when the Reserve Bank last
issued a quarterly Monetary Policy Statement, we projected
inflation in the June quarter to be just 0.3 per cent, and
inflation in the year to March 2001 to be just 1.6 per cent.

What a lot can change in two and a half months! Even
before that May Statement was published, the Government had
sharply increased the tax on cigarettes, adding around 14
per cent to their price. Within hours of the publication of
that May Statement, the trade-weighted measure of the New
Zealand dollar had depreciated close to its lowest level in
history. Within weeks of the publication of that May
Statement, the price of petrol had increased by some 15 per
cent, the result of a sharp further increase in the
international price of oil and of the depreciation of the
New Zealand dollar.

As a result, it was clear well before
the announcement of the actual inflation figure for the June
quarter, of 0.7 per cent, that inflation for that quarter
would considerably exceed our original estimate of 0.3 per
cent, and that inflation for the year to March 2001 will
almost certainly considerably exceed our estimate of 1.6 per
cent.

Some commentators are suggesting that inflation is
now likely to exceed 3 per cent for the year to December
2000, and almost all commentators are at least expecting
inflation to well exceed our mid-May estimate.

What does
this imply for the way in which the Reserve Bank implements
monetary policy? It is clearly inappropriate for me to
speculate on what we may or may not do when we release our
August Monetary Policy Statement in two weeks’ time, but I
want to use this occasion to reiterate and emphasise some of
the points relevant to this issue. In all cases, these
points have been made previously, but I suspect that some of
them may have been forgotten or ignored.

Of caveats and
underlying inflation

The first point to reiterate is that,
from the time I signed my very first agreement with the
Minister of Finance (the Hon David Caygill) in early 1990,
shortly after the passage of legislation requiring the
Reserve Bank to use monetary policy to deliver price
stability, the Bank has been expected not to react to price
changes arising from things like big changes in
international prices and changes in indirect taxes.

We
used to refer to these things as "caveats", and to calculate
the inflation rate excluding the impact of such "caveatable"
shocks. For convenience, we used to refer to the inflation
rate excluding such caveatable shocks as the "underlying
inflation rate".

In the agreement I signed with the
present Minister of Finance, the Hon Dr Michael Cullen, in
December last year, as in the agreement signed with the Rt
Hon Winston Peters in late 1997, the wording is slightly
different from the wording used in 1990, but the substance
is the same, namely that

"There is a range of events that
can have a significant temporary impact on inflation as
measured by the CPI, and mask the underlying trend in prices
which is the proper focus of monetary policy. These events
may even lead to inflation outcomes outside the target
range. Such disturbances include, for example, shifts in the
aggregate price level as a result of exceptional movements
in the prices of commodities traded in world markets,
changes in indirect taxes, significant government policy
changes that directly affect prices, or a natural disaster
affecting a major part of the economy. When disturbances of
(this) kind…arise, the Bank shall react in a manner which
prevents general inflationary pressures emerging."

And the
Reserve Bank is directed to ignore, or "look through" in the
jargon, the price effects of such events not in order to
make my life easier but to make your life easier. In other
words, the Bank is directed not to react to such one-off
price shocks on the grounds that trying to offset them would
involve more economic cost than would be warranted. For
example, while monetary policy could in principle be
tightened aggressively so that other prices in the economy
would fall sufficiently to offset the direct price effects
of an increase in the international price of oil, the
Minister has decided, and I have agreed, that doing that
would involve more economic and social damage than could be
justified.

We no longer calculate "underlying inflation"
in the way we used to do, and that is true for a whole raft
of reasons, including the fact that there was always some
public suspicion that "underlying inflation" was a Reserve
Bank invention to help Don Brash keep his job. But the
reality which that term reflected is as valid today as it
was a decade ago. In other words, we are not interested in
trying to use monetary policy to suppress the price changes
which emanate from international oil price changes or from
changes in indirect taxation.

And when we look forward to
the end of the year, it seems pretty clear that much of the
sharp increase in inflation which is now expected by most
commentators will be the direct result of such factors, and
should as a result be ignored by the Reserve Bank in setting
monetary policy.

Partly because we expressly don’t react
to certain kinds of price changes, actual inflation can
often be expected to fluctuate over quite a wide range –
certainly over the full 0 to 3 per cent range, and
occasionally outside that range. And we set interest rates
with the objective of keeping inflation somewhere near the
middle of the target range in one to two years’ time
precisely because we know that in practice there will be all
sorts of unexpected shocks and developments, ranging from
Asian crises to changes in cigarette taxes, which will move
prices both up and down, away from that mid-point. We
improve our chances of having inflation remain within the
target range most of the time by constantly aiming to keep
inflation near the mid-point of the range in the
medium-term. But we recognise that there will be all kinds
of developments which will result in somewhat different
outcomes, and indeed should result in somewhat different
outcomes.

But it is crucially important to stress that
the Reserve Bank can ignore the impact of these one-off
"shocks" to the inflation rate only if we New Zealanders do
not use them as an excuse to start a more generalised and
enduring increase in the inflation rate.

If a doctor, in
reviewing his or her fees, says "Well, the CPI went up by 3
per cent, so I had better put up my fees by 3 per cent
also", then we have a problem.

If a producer of widgets
sees that the CPI has increased by 3 per cent, and
automatically puts his prices up too, then we have a
problem.

If local authorities see a 3 per cent increase in
the CPI as adequate justification for them to increase rates
and fees by that amount, then we have a problem.

And if
wages and salaries are automatically increased by 3 per cent
to compensate for the increase in the CPI, then we have a
problem.

The reality is that, when the international
price of oil goes up – to use the current example – we New
Zealanders become poorer, and it is utterly futile to
suppose that we can compensate ourselves for that fact by
giving ourselves higher incomes. To the extent that some New
Zealanders succeed in winning such compensation, the gain is
achieved at the expense of other New Zealanders, since in
aggregate we are all worse off.

To put it bluntly, if the
Reserve Bank is to be able to "look through" the impact of
things like the increase in petrol and cigarette prices in
implementing monetary policy, we New Zealanders also need to
"look through" the impact of those things on the CPI. To the
extent that we don’t, and instead seek compensation for the
impact of those things on the CPI, the Bank will need to
tighten monetary policy to a greater extent. The only
alternative would be permanently higher inflation, and that
would help nobody and hurt those least able to protect
themselves.

In recent years, the Reserve Bank has been
happy to report that inflationary expectations are now well
anchored at a low level. We have been able to say that, as a
result, we expect that smaller adjustments in interest rates
will be required to maintain price stability, and of course
this is good news. It would be a tragedy if sloppy thinking
by price setters, and a return to an indexation mentality,
meant that the benefits of those lower inflationary
expectations were lost.

The impact of the exchange rate on
inflation

The second point I want to reiterate is the
relevance of the exchange rate to inflation.

The exchange
rate has two effects on the inflation rate. First, there is
the more or less immediate impact of movements in the
exchange rate on the prices of goods and services which are
traded internationally, or which could be traded
internationally. We know, for example, that when the New
Zealand dollar depreciates the New Zealand dollar price of
oil goes up, and the price of petrol goes up with it, quite
apart from any impact of an increase in the international
price of oil measured in US dollars. Similarly, the price of
milk goes up, even though milk is not imported, because the
New Zealand dollar price of milk on the international market
goes up with the depreciation of the New Zealand dollar.
These so-called "direct price effects" of a movement in the
exchange rate typically affect New Zealand’s inflation rate
quite quickly, usually within six to 12 months.

We used to
think that a 1 per cent depreciation in the exchange rate
would produce an increase in the inflation rate of about 0.3
per cent within 12 months as a result of these more or less
immediate direct effects. But for some years now, the impact
of a change in the exchange rate seems to have produced a
much smaller impact on inflation than that, for reasons
which are not entirely clear. The same relatively mild
impact of exchange rate movements on inflation has been
observed in Australia, Canada, and the United Kingdom in
recent years.

But whether the impact is as big as we
thought it was in the early nineties or as small as it seems
to have been more recently, we now recognise that this
short-term impact of movements in the exchange rate is not
something which always calls for a monetary policy response.
This is because the effects of such exchange rate movements
on the inflation rate may have come and gone before
adjustments in monetary policy can have much offsetting
effect on the inflation rate.

But again, the Reserve
Bank’s ability not to react to the temporary inflation
movements associated with exchange rate changes depends on
whether we New Zealanders accept that the direct price
effects of exchange rate depreciation are not matters which
justify our seeking compensation through higher incomes. If
we collectively seek such compensation, then the Bank is
faced not with a one-off price level adjustment but with the
potential for ongoing upwards pressure on prices. In that
event, we would have no alternative than to lean against
that by running a somewhat tighter monetary policy than
otherwise.

The second way in which the exchange rate is
relevant to inflation is through the effect which the
exchange rate has on the demand for New Zealand-produced
goods and services. When the exchange rate depreciates,
goods and services produced in New Zealand become cheaper
relative to the price of goods and services produced abroad.
Foreigners seek to buy more of the goods and services
produced here, and so also do New Zealanders. In other
words, our exports become more price-competitive overseas,
and domestically-produced goods and services become more
price-competitive vis-a-vis imports. Those producing exports
and import-substitutes see an increase in their sales. If
they are operating at full capacity, they will seek to
expand production by increasing investment and hiring more
staff.

And this is great – until such time as the demand
for additional resources from exporters and those producing
import substitutes collides with the demands for resources
emanating from the domestic, so-called "non-tradable", parts
of the economy. If the total demand for resources is greater
than the resources available, then at some point inflation
will begin to develop.

So in assessing the appropriate
stance of monetary policy, the Reserve Bank can not ignore
these indirect effects of the exchange rate on the total
demand for New Zealand goods and services. The exchange rate
is always relevant to assessing the appropriate stance of
monetary policy.

Does this mean that the Reserve Bank has
some secret exchange rate target, or perhaps some secret
exchange rate floor? Does it mean that we might increase
interest rates to "prop up" the exchange rate? Absolutely
not. It just means, to repeat, that we have to set overnight
interest rates in recognition of these medium-term effects
of the exchange rate on total demand. If the export sectors,
and the sectors supplying import substitutes, were demanding
more resources than the domestic sectors of the economy were
willing to release, then interest rates would need to rise
somewhat to avoid that conflict generating on-going
inflation.

Does this mean that the Reserve Bank has
resurrected the Monetary Conditions Index (MCI)? Absolutely
not again, if by that is meant: are we seeking some
semi-automatic movement in interest rates to offset
movements in the exchange rate? If the exchange rate moves,
either up or down, we always have to try to assess the
reasons for that movement. It may be, for example, that a
depreciation in the exchange rate reflects actual or
potential weakness in international commodity prices which
would have a disinflationary impact on the economy fully
offsetting the inflationary impact of the depreciation, thus
requiring no offsetting interest rate increase.

But the
exchange rate does affect the demand for New Zealand-made
goods and services, and therefore has medium-term
implications for the inflation rate. So while we can often
ignore the direct and relatively immediate price effects of
movements in the exchange rate, assuming that these direct
price effects do not generate "second-round" inflation
pressures, we can not ignore these medium-term
implications.

Monetary policy and the balance of payments
deficit

Finally, allow me some observations on the
relationship between monetary policy and the balance of
payments.

I have often argued that monetary policy has no
ability to influence the balance of payments deficit,
certainly on any kind of sustainable basis. Indeed, I do not
even know whether, if I were instructed to use monetary
policy to reduce the deficit (through the Government’s using
the so-called "over-ride" provision in the legislation), I
would be tightening or easing monetary policy. Tightening
policy would presumably cause the exchange rate to
appreciate, making the deficit larger, but might also slow
domestic demand, making the deficit smaller. The problem
arises from the fact that no central bank has discovered a
reliable technique for changing the mix of monetary
conditions so that, for example, monetary policy could be
tightened through an increase in interest rates without at
the same time putting upward pressure on the exchange
rate.

I have also argued in the past that, eventually, in
a situation where the exchange rate is floating and the
government is running a fiscal surplus, the balance of
payments deficit would reduce of its own accord. That is
based on a recognition that, in those circumstances, a
balance of payments deficit reflects the fact that the
private sector is spending more than its income – or in
other words, is a net borrower – and that this situation is
unlikely to continue indefinitely. At some point, either New
Zealanders will decide to borrow less or foreigners will
decide to lend us less. If foreigners tire of lending us
their savings before we New Zealanders tire of borrowing
them, the likely outcome is a change in the mix of monetary
conditions, in the direction of a lower exchange rate and
somewhat higher interest rates. We know that such a change
in the mix of monetary conditions tends to reduce the
balance of payments deficit (and if we had had any doubts on
this score they would have been allayed by the speed at
which the large balance of payments deficits which some
Asian countries had prior to the recent crisis were
converted into surpluses).

The concern which I have
expressed on previous occasions, however, is about the
social and economic costs which might be paid if the change
in the mix of monetary conditions takes place too abruptly,
as it certainly did in the Asian crisis economies.

It is
at least possible, however, that what we have been
witnessing in recent months is in fact a gradual change in
the mix of monetary conditions of the sort which will, over
the next few years, see quite a significant reduction in the
balance of payments deficit. Certainly the exchange rate, on
any measure, is at an historically low level and is
providing strong stimulus to export industries and to those
producing import substitutes. Interest rates are not at a
particularly high level – indeed, they are well below the
levels reached in the mid-eighties and mid-nineties, at
least in nominal terms – and I suspect that that may have
something to do with the fact that New Zealanders are
getting a little less enthusiastic about borrowing at much
the same time as foreigners are getting a little less
enthusiastic about lending us their savings.

But it is
important that we all understand what curing the balance of
payments deficit implies.

It implies that for a period of
some years those producing exports and import substitutes
will enjoy rather stronger levels of growth, in sales and
incomes, than those producing goods mainly for the domestic
market. In plain English, that means that farmers, export
manufacturers, fishing companies, tourist operators, and the
like are likely to be relatively prosperous, while those in
industries such as construction and retailing may be
somewhat less so.

It implies that consumption spending may
grow rather more slowly than total disposable income, with
the difference going into increased saving.

It implies
that interest rates may favour savers rather than borrowers
for a period, and that as a consequence household sector
borrowing may grow more slowly than household sector income,
rather than substantially faster than household sector
income, as for the last 15 years.

None of these changes
would be good or bad in themselves, though no doubt there
would be many who would welcome signs that we New Zealanders
have an ability to live within our means.

But they would
certainly involve changes which we would all need to be
mindful of in interpreting economic indicators. For example,
whereas once upon a time the state of the residential
building industry was of fundamental importance in assessing
the strength of the New Zealand economy, it may well be that
over the next few years, as resources are attracted into
export and import-competing industries, the residential
building industry becomes a little less important in a
relative sense. Similarly, the rate at which consumer
spending grows may slow somewhat in the years ahead, after a
period during which it grew substantially faster than
household sector income. At the same time, we may see strong
growth in industries, and regions, which have a heavy
emphasis on exporting.

Mr Chairman, as you can see, I have
been careful to avoid giving even the slightest hint about
what the Reserve Bank will be saying in its Monetary Policy
Statement in two weeks’ time. But I have appreciated this
opportunity of putting that Statement into context, and
repeating some of the messages which may have been lost
sight of in recent months. Most important of all, the Bank’s
ability to ignore the "spike" in inflation which seems
likely to lie ahead of us depends crucially on the
willingness of New Zealanders themselves to ignore that
spike in negotiating increases in their own incomes. If they
do not, there can not be the slightest doubt that monetary
policy will need to be tighter than would otherwise be the
case.

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